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The economic analysis of stocks: Airline companies

July 29th, 2008 · No Comments

What moves airline stocks? The energy cost that is required to move the planes, one would say nowadays. Well, that is true, but only to a certain degree..

The business model of airlines is relatively simple. If you have some spare cash laying around, you could almost do it yourself. Here are some of the main elements:

  • Operating cost of planes; fuel, crews, old or new planes, bought or leased
  • Having places to fly to and from, that is, one has to have slots and routes.

It is absolutely true that the airline stocks have been crippled by the rising energy prices. We’ll give you one little statistic: in 2008, a full 34% of operational cost of airlines are the result of fuel cost, as little ago as 2003, this was only 20%, that’s a pretty hefty difference.

But it only matters because the market has become much more competitive, and even today a considerable part of these rising fuel cost are just presented to the customer (often in the form of a ‘fuel surcharge’). So as important as it is, it is not a make or break criteria.

For instance, South West Airlines has managed to reduce those fuel cost by smart hedging. By pre-buying much fuel at fixed prices, it now enjoys 50% lower fuel cost than many other airliners.

However, this works well up till now, but, as most observers of financial markets will be well aware off, there is also such a thing as ‘stupid hedging’. Hedging itself adds cost, and if the price movement is the other way than you expect, you might very well end up with a double whammy.

Another way to reduce fuel cost is to have a modern fleet. This really works. If you don’t believe us, belief The Economist: (or from Greg Mankiw’s blog, author of one of the best-selling introductory economics texts today):

  • demand for new, more fuel-efficient aircraft has never been greater. The latest versions of the Airbus A320 and Boeing 737, the single-aisle workhorses for which demand is strongest, are up to 40% cheaper to run than the vintage planes some American airlines still use.

But here is a little bit of an awkward dilemma, those airliners with the oldest fleet are the ones who stand most to benefit from upgrading, but are generally least able to do so, as their fuel cost are, well, higher than those with a more modern (and hence more energy efficient) fleet.

That leaves us turning to the routes airlines fly. In the good old days, life was relatively simple. Most airliners had numerous monopoly or quasi monopoly routes, because most of them were national carriers, which were given privileges on most routes to the ‘national hub’.

At most, they had to endure competition from the carrier going the opposite way (Air France flying to, say Lisbon had TAP flying from Lisbon to Paris and back), but more often than not, competitive forces were really contained.

Airlines almost invariably operate on the so called ‘hub and spoke‘ model, that is, they have a few hubs in their network of routes that function as central points, collecting flights, greatly diminishing the need for routes (‘spokes’).

Hubs are where you change planes if you want to go from A to C, but there is no direct flight from A to C because such a flight would be uneconomical, that is, too few passengers would travel on it. But if flights from A to B are economical, and those from B to C also, B will function as a hub (large capacity airports usually close to big agglomerations).

Big hubs are Chicago, London, New York, Amsterdam, for instance. We will not go into it here, but the ‘hub and spoke’ system is by no means a necessity. Smaller planes could bypass the hubs and fly the less economical routes (they could also fly less frequently, although that would not be very convenient for many travellers).

Most of what we now have discussed doesn’t require much special competence, that’s why we started this article by arguing that if you had some (a considerable amount) cash laying around, you could start your own airline.

The only special requirement would be up to now is how to get your hands on a profitable route and establish your own hub. And this was, until not too long ago, not really dictated by the forces of competition, but by ‘the forces of tradition’.

Some carriers (national carriers in most of the world, in the US the big ones each had their own hubs) just happened to be there because, well, they happened to be there.

The remaining important element turns out to be rather critical, and that’s a capability that is called yield management. If you don’t know what this means, allow us to explain, because we’re pretty sure you will be familiar with one if it’s most disturbing phenomena.

Have you ever asked the guy sitting next to you on a plane how much he paid for his ticket? The bets are on that it will be significantly different from the price you’ve paid, perhaps even wildly so. While this little piece of knowledge is likely to make the journey just a little bit more pleasing or frustrating, it’s a fact of life. This is how airlines make money.

Yield management is the art to balance price and load. Flying a plane is mostly a fixed cost business, so marginal cost (that is, how much extra does it cost to fly an additional passenger) is virtually zero. Any additional passengers will add almost all to the bottom line (even more so today now you have to pay for your drinks and stuff).

The art is to find out what they are willing to pay for it, and charge them as close as possible to that. This, by the way, is complex stuff. Understanding this will make the phenomenon of ‘last minute tariffs’ immediately clear. It’s a desperate attempt by airlines to get half-full (or even rather empty) planes filled up.

But reality is quite a bit more complex, because many customers have figured this out, waiting until the last moment to book in the expectation it would be cheaper. This is bad for airlines, as it exacerbates the problem of getting the plain as full as possible.

One thing that has been around for a long time is different flying classes, business customers are generally less price sensitive, and this fact has been exploited mercilessly.

Ok, you have a little bit more room in business, a few more movies to choose from, and real metal cutlery, but those differences are not nearly worth the price differences between classes. But this is only yield management at it’s most crudest.

In reality, when to charge what tariffs to whom is taken up by complex software algorithms that are the industries most guarded secrets.

In the last two decades, two new elements have been introduced:

  • Liberalization, which caused a great deal more competition
  • New business models, the ‘no frills’ low cost carriers

The cosy relations between airliners has been shaken up by these two elements. In a way, the emergence of the low-cost carriers has been induced by the difficulty of getting into the most profitable slots in big airports.

Flying from smaller, local airports (many of them were actually vying for business, like Charleroi in Belgium) reduced cost quite drastically. Having uniform fleets created economies in maintenance, training, and the like, and further cuts were attained by electronic booking systems over the internet and a more frugal flying experience.

Internet booking especially provided an opportunity to take yield management to new hights, as customers can now choose between different dates, times, and prices providing a wealth of feedback about their true demand.

The losening grip on their traditional hubs has forced networks enter in larger aliances, reaping economies of scale without having to grow themselves.

Tags: Economics of stock analysis